Where can you buy at a discount to replacement value?

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When redeveloping/replacing, will Grade A or Grade B office buildings provide most value?

With the near record levels of capital targeting Asia Pacific, the price of core real estate in the region has increased substantially over the last few years. The scarcity of stock in gateway markets has left investors with the challenge of deploying capital without driving prices to unsustainable levels.

Given current market conditions, it’s useful for investors to compare the prospective purchase price of a commercial building to what it would cost to replace/redevelop a similar structure in the same area, even if just hypothetically. Acquiring an asset at a sizable discount to its replacement cost means lower risk for the buyer and allows higher returns than would be achieved with redevelopment.

Attractive pricing for the buyer

Across the CBD’s of Tokyo, Hong Kong, Sydney and Singapore, we compared the prospective purchase price of an average Grade A office building to what it would cost to re-develop a Grade B commercial building in the same area.
‘Replacement cost’ is defined as the cost to demolish the existing structure, construct a new medium Grade A office building, finance the project and include a reasonable return to compensate for development risks. For this exercise, land costs have been included in the capital value of the Grade B building.

Valuations in Tokyo and Hong Kong

Prime CBD office assets are keenly priced in Tokyo and Hong Kong, as foreign capital has driven valuations steeply upwards in the current market upswing. In both cities, a buyer may find less value in acquiring a Grade A building at a discount to average Grade B capital values plus replacement cost.

This is good news if you own a property in Tokyo as re-developing a Grade B commercial building is an attractive proposition with higher rents and capital values comfortably covering replacement costs and incentivising development. Recently, mid-sized developers that plan to redevelop/refurbish older buildings are the main buyers in Tokyo.

Whilst the dollar value associated with re-developing a Grade B commercial building will also be attractive in Hong Kong, pursuing the re-development route will be challenging as there are very few assets on market and a number of legal and regulatory hurdles, especially for strata-title buildings.

More value in Sydney and Singapore

If you are a looking to buy an asset, you will find increased value by acquiring a medium Grade A building in the CBDs of Sydney or Singapore at a discount to a Grade B commercial building plus replacement cost. In Singapore, more office stock (both CBD en-bloc offices and some strata-title prime offices) are on the market as occupancy and rents fall. Therefore, prospective buyers will have more options. On the other hand, strong demand for office assets in Sydney’s CBD means that investors may need to look towards Grade A buildings in secondary markets like North Sydney.